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Futures and Forwards A future is a contract between two parties requiring deferred delivery of underlying asset (at a contracted price and date) or a final cash settlement. Both parties are obligated to perform and fulfill the terms. A customized futures contract is called a Forward Contract.

Futures and Forwards

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Futures and Forwards. A future is a contract between two parties requiring deferred delivery of underlying asset (at a contracted price and date) or a final cash settlement. Both parties are obligated to perform and fulfill the terms. A customized futures contract is called a Forward Contract. - PowerPoint PPT Presentation

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Page 1: Futures and Forwards

Futures and Forwards

A future is a contract between two parties requiring deferred delivery of underlying asset (at a contracted price and date) or a final cash settlement. Both parties are obligated to perform and fulfill the terms. A customized futures contract is called a Forward Contract.

Page 2: Futures and Forwards

Cash Flows on Forwards

Pay-off Diagram:

Spot price of underlying assets

Seller’s pay-offs

Buyer’s pay-offs

FuturesPrice

Page 3: Futures and Forwards

Why Forwards?

They are customized contracts unlike Futures

and they are: Tailor-made and more suited for certain

purposes. Useful when futures do not exist for

commodities and financials being considered. Useful in cases futures’ standard may be

different from the actual.

Page 4: Futures and Forwards

Futures & Forwards Distinguished

FUTURES FORWARDS

They trade on exchanges Trade in OTC markets

Are standardized Are customized

Identity of counterparties is irrelevant

Identity is relevant

Regulated Not regulated

Marked to market No marking to market

Easy to terminate Difficult to terminate

Less costly More costly

Page 5: Futures and Forwards

Important Terms

Spot Markets: Where contracts for immediate delivery are traded.

Forward or Futures markets: Where contracts for later delivery are traded.

Both the above taken together constitute cash markets.

Page 6: Futures and Forwards

Important Terms

Futures Series: All with same delivery month with same underlying asset.

Front month and Back month. Soonest to deliver or the nearby contract Commodity futures vs. financial futures. Cheapest to deliver instruments. Offering lags.

Page 7: Futures and Forwards

Important Terms

Variation Margin Deliverables Substitute for Future Cash Market

Transactions Settlement in Cash

Page 8: Futures and Forwards

Interest Rate Futures

Two factors have led to growth:

Enormous growth in the market for fixed income securities.

Increased volatility of interest rates.

Page 9: Futures and Forwards

Futures & Risk Hedging

Interest Rate Risk Exchange Rate Risk Commodity Price Risk Equity Price Risk

Page 10: Futures and Forwards

Hedging Interest Rate Risk

A CFO needs to raise Rs.50 crores in February

20XX to fund a new investment in May 20XX, by

selling 30-year bonds. Hedge instrument

available is a 20-year, 8% Treasury -bond based

Future. Cash instrument has a PV01 of

0.096585, selling at par and yielding 9.75%. It

pays half-yearly coupons and has a yield beta of

0.45. Hedge instrument has a PV01 of 0.098891.

Page 11: Futures and Forwards

Hedging Interest Rate Risk

Hence, FVh = FVc [PV01c / PV01h] y

= 50 [0.096585 / 0.098891] 0.45

= Rs.21.98 Crores

If FV of a single T-Bond Future is Rs.10,00,000

then, Number of Futures (Nf) = 21.98/0.1

= 219.8 Futures

Page 12: Futures and Forwards

Hedging Interest Rate Risk

If corporate yield rises by 80bp by the time of actual offering, it has to pay 10.55% couponsemi-annually to price it at par. Thus, it has to payRs.50,00,00,000 0.0080 0.5 = Rs.20,00,000 more every six months in terms of increasedcoupons.

This additional amount will have a PV at 10.55%

= 20,00,000 PVIFA5.275%, 60 = Rs.3,61,79,720 Rs.3.618 Crores

Page 13: Futures and Forwards

Hedging Interest Rate Risk

Since corporate yield increases by 80bp, T-Bondyield will increase by 178bp resulting in anincreased profit on short position in T-bondfutures

= 22,00,00,000 0.0178 0.5= Rs.19,58,000 half yearly, which has a PV= 19,58,000 PVIFA4,89%,40

= Rs.3,41,09,729= Rs.3.411 Crores

Page 14: Futures and Forwards

Why Not perfect Hedge?

PV01 provides accurate and effective hedge for small changes in yields.

PV01s of cash and hedge instruments change at different rates.

PV01s need to be recalculated frequently (practice is every 5bps). This can change the residual risk profile.

Additional costs related to recalculations need to be kept in mind.

Page 15: Futures and Forwards

A Transaction on the Futures Exchange.

Buyer Buyer’sBroker

FuturesExchange

3

Buyer’s Broker’sCommission Broker

FuturesClearingHouse

Buyer’s Broker’sClearing Firm

Buyer’s Broker’sClearing Firm

Seller’s Broker’sCommission Broker

Seller’sBroker

Seller

1a 1b Buyer and seller instruct their respective brokers to conduct a futures transaction.2a 2b Buyer’s and seller’s brokers request their firm’s commission brokers execute the transaction.3 Both floor brokers meet in the pit on the floor of the futures exchange and agree on a price.4 Information on the trade is reported to the clearinghouse.5a 5b Both commission brokers report the price obtained to the buyer’s and seller’s brokers.6a 6b Buyer’s and seller’s brokers report the price obtained to the buyer and seller.7a 7b Buyer and seller deposit margin with their brokers.8a 8b Buyer’s and seller’s brokers deposit margin with their clearing firms.9a 9b Buyer’s and seller’s brokers’ clearing firms deposit premium and margin with clearinghouse.

1a

6a

7a

2a5a

48a 8b

9a 9b

2b5b

1b

6b

7b

Note: Either buyer or seller (or both) could be a floor trader, eliminating the broker and commission broker.

Page 16: Futures and Forwards

Exchange Rate Risk Hedging

Currency hedge is a direct hedge and not

a cross hedge as in case of interest rate

risk hedging. Hence, a hedge ratio of 1:1

works very well.

Page 17: Futures and Forwards

Forward Rate Agreements (FRAs)

FRAs are a type of forward contract wherein contracting parties agree on some interest rate tobe paid on a deposit to be received or made at alater date.

The single cash settlement amount is determinedby the size of deposit (notional principal), agreedupon contract rate of interest and value of thereference rate prevailing on the settlement date.Notional principal is not actually exchanged.

Page 18: Futures and Forwards

Determination of Settlement Amount

Step-1:Take the difference between contract rate andthe reference rate on the date of contract settlement

Step-2: Discount the sum obtained using reference rateas rate of discount.

The resultant PV is the sum paid or received. Thereference rate could be LIBOR (most often used) or any other well defined rate not easily manipulated.

Page 19: Futures and Forwards

Hedging with FRAs

Party seeking protection from possibleincrease in rates would buy FRAs (party is called purchaser) and the one seekingprotection from decline would sell FRAs(party is called seller).

These positions are opposite of thoseemployed while hedging in futures.

Page 20: Futures and Forwards

Illustration

A bank in U.S. wants to lock-in an interest rate for$5millions 6-month LIBOR-based lending thatcommences in 3 months using a 39 FRA. At the time 6-month LIBOR (Spot Rate) is quoted at 8.25%. Thedealer offers 8.32% to commence in 3 months. U.S. bankoffers the client 8.82%. If at the end of 3 months, whenFRA is due to be settled, 6-month LIBOR is at 8.95%,bank borrows at 8.95% in the Eurodollar market andlends at 8.82%.

Page 21: Futures and Forwards

Illustration

Profit/Loss= (8.82-8.95) 5 millions 182/360= - $3286.11

Hedge Profit/Loss = D(RR-CR)NP182/360= 1 (8.95-8.32) 5 millions182/360= $15925

Amount Received/Paid= $15925/1.04525= $15235.59

Note: 8.95 182/360 = 4.525

Page 22: Futures and Forwards

Index Futures Contract

It is an obligation to deliver at settlement an amount equal to ‘x’ times the difference between the stock index value on expiration date and the contracted value

On the last day of trading session the final settlement price is set equal to the spot index price

Page 23: Futures and Forwards

Illustration (Margin and Settlement)

The settlement price of an index futures contract on aparticular day was 1100. The multiple associated is 150.The maximum realistic change that can be expected is 50points per day. Therefore, the initial margin is 50×150 =Rs.7500. The maintenance margin is set at Rs.6000. Thesettlement prices on day 1,2,3 and 4 are 1125, 1095,1100 and 1140 respectively. Calculate mark-to-marketcash flows and daily closing balance in the account ofInvestor who has gone long and the one who has goneShort at 1100. Also calculate net profit/(loss) on eachcontract.

Page 24: Futures and Forwards

IllustrationLong Position:Day Sett. Price Op. Bal. M-T-M CF Margin Call Cl. Bal 1 1125 7500 + 3750 - 11250 2 1095 11250 - 4500 - 6750 3 1100 6750 + 750 - 7500 4 1140 7500 + 6000 - 13500Net Profit/(loss) = 3750-4500+750+6000 = Rs. 6000

Short Position:Day Sett. Price Op. Bal. M-T-M CF Margin Call Cl. Bal 1 1125 7500 - 3750 2250 6000 2 1095 6000 + 4500 - 10500 3 1100 10500 - 750 - 9750 4 1140 9750 - 6000 2250 6000Net Profit/(loss) = -3750+4500-750-6000 = (-) Rs. 6000

Page 25: Futures and Forwards

Pricing of Index Futures Contracts

Assuming that an investor buys a portfolio consisting of stocks in the index, rupee returns are:

RI = (IE – IC) + D, where

RI = Rupee returns on portfolio

IE = Index value on expiration

IC = Current index value

D = Dividend received during the year

Page 26: Futures and Forwards

Pricing of Index Futures Contracts

If he invests in index futures and invests the money in risk free asset, then

RIF = (FE – FC) + RF,

where

RIF = Rupee return on alternative investment

FE = Futures value on expiry

FC = Current futures value

RF = Return on risk-free investment

Page 27: Futures and Forwards

Pricing of Index Futures Contracts

If investor is indifferent between the two options, then

RI = RIFi.e. (IE-IC) + D = (FE-FC) + RF

Since IE = FEFC = IC + (RF – D)

(RF – D) is the ‘cost of carry’ or ‘basis’ and the futures contract must be priced to reflect ‘cost of carry’.

Page 28: Futures and Forwards

Stock Index Arbitrage

When index futures price is out of sync with the theoretical price, the an investor can earn abnormal risk-less profits by trading simultaneously in spot and futures market. This process is called stock index arbitrage or basis trading or program trading.

Page 29: Futures and Forwards

Stock Index Arbitrage: Illustration

Current price of an index = 1150

Annualized dividend yield on index = 4%

6-month futures contract price = 1195

Risk-free rate of return = 10% p.a.

Assume that 50% of stocks in the index will

pay dividends in next 6 months. Ignore

margin, transaction costs and taxes. Assume a

multiple of 100. Is there a possibility of stock

Index arbitrage?

Page 30: Futures and Forwards

Stock Index Arbitrage: Illustration

Fair price of index futureFC = IC + (RF – D)

= 1150 + [(1150×0.10×0.5)-(1150×0.04×0.5)] = 1150 + 34.5 = 1184.5 (hence it is overpriced)

Investor can buy a portfolio identical to index and short-sell futures on index.If index closes at 850 on expiration date, thenA. Profit on short sale of futures (1195 – 850) ×100 = Rs.34,500B. Cash Div recd on port. (1150 × 0.04 × 0.5 × 100 = Rs. 2,300C. Loss on sale of port. (1150 – 850) ×100 = ( - ) Rs.30,000D. Net Profit = 34,500 +2,300 – 30,000 = Rs.6,800E. Half yearly return = 6800 ÷ (1150×100)=0.0591 = 5.91%F. Annual return (1.0591)2 – 1 = 0.1217 = 12.17%

Page 31: Futures and Forwards

Stock Index Arbitrage: Illustration

If index closes at 1300,

A. = (-) 10,500

B. = 2,300

C. = 15,000

D. = 6,800 = 12.17% p.a.

Page 32: Futures and Forwards

Application of Index Futures

In passive Portfolio Management:

An investor willing to invest Rs.1 crore can buy futures contracts instead of a portfolio, which mimics the index.

Number of contracts (if Nifty is 5000)

= 1,00,00,000/5000 ×100 = 20 contracts

Advantages: Periodic rebalancing will not be required. Potential tracking errors can be avoided. Transaction costs are less.

Page 33: Futures and Forwards

Application of Index Futures

In Beta Management:

In a bullish market beta should be high and in a bearish market beta should be low i.e. market timing and stock selection should be used.

Consider following portfolio and rising market forecast.

Equity : Rs.150 millions

Cash Equivalent : Rs.50 millions

Total : Rs.200 millions

Assume a beta of 0.8 and desired beta of 1.2

Page 34: Futures and Forwards

Application of Index Futures

The Beta can be raised by,a. Selling low beta stocks and buying high beta stocks

and also maintain 3:1 ratio. Or,b. Purchasing ‘X’ contracts in the following equation:

150 × 0.8 + 0.02 × X = 200 × 1.2i.e. X = (200 × 1.2 – 150 × 0.8) / 0.02

= 6000 contracts, assuming Nifty future available at Rs.5000, multiple of 4 and beta of contract as 1.0

No. of contracts will be 600 for a multiple iof 40 and 240 for a multiple is 100.

Page 35: Futures and Forwards
Page 36: Futures and Forwards

Euro-rate Differentials (Diffs)

Introduced on July 6, 1989 in US, it is a

futures contract tied to differential between

a 3-month non-dollar interest rate and

USD 3-month LIBOR and are cash settled.

Page 37: Futures and Forwards

Euro-rate Differentials (Diffs)

Example: If USD 3-month LIBOR is 7.45 and

Euro 3-month LIBOR is 5.40 at the settlement

time, the diff would be priced at 100 – (7.45 –5.40)

= 97.95. Suppose in January, the March

Euro/dollar diff is prices at 97.60, this would

suggest that markets expects the differential

between USD LIBOR and Euro LIBOR to be

2.40% at settlement in March.

Page 38: Futures and Forwards

Euro-rate Differentials (Diffs)

They are used for:

1. Locking in or unlocking interest rate differentials when funding in one currency and investing in another.

2. Hedging exposures associated with non-dollar interest-rate sensitivities.

3. Managing the residual risks associated with running a currency swap book.

4. Managing risks associated with ever changing interest-rate differentials for a currency dealer

Page 39: Futures and Forwards

Foreign Exchange Agreements (FXAs)

They allow the parties to hedge movements

in exchange rate differentials without

entering a conventional currency swap. At

the termination of the agreement, a single

payment is made by one counterparty to

another based on the direction and the

extent of movement in exchange rate differentials.